1. Page 1CS 851 1 March 2002 Value Based Software Reuse Investment A Review Susan K. Donohue Department of Systems and Information Engineering

2. Page 2CS 851 1 March 2002 Agenda Review of Wednesday’s Topics Today’s Topics CCA VBRI (Value Based Reuse Investment) A Summary of My Observations on the Paper Questions

3. Page 3CS 851 1 March 2002 Reminder We are reviewing a method for valuing information technology infrastructure investments, which aren’t traded…yet which provide companies with strategic and operational benefits. There is development for reuse and development with reuse

4. Page 4CS 851 1 March 2002 DTA Notation: Decision Node - square State of Nature / Chance Nodes – circle - assign probabilities Endpoints may have circles, may have triangles, or may have no notation at all

5. Page 5CS 851 1 March 2002 DTA Payoffs or expected values are listed at the endpoints Outcomes are mutually exclusive Solve a DT by working your way from “back to front,” in a fold-back, dynamic programming fashion

6. Page 6CS 851 1 March 2002 DTA Problems include tree size (decision forests) and fundamental theoretical problems in handling risk.

7. Page 7CS 851 1 March 2002 CCA Uses option pricing theory (Black- Scholes) and decision trees “Economically corrected” DTA CCA overcomes the main drawback to DTA -- that DTA cannot handle the fact that discount rates need to change over time as risks are resolved or as risks crop up

8. Page 8CS 851 1 March 2002 CCA An option is a financial instrument with an asymmetric property – one has the right to buy or sell an asset; however, one does not have to exercise the option.

9. Page 9CS 851 1 March 2002 CCA Call The right to buy an asset at a specified time in the future for a specified exercise or strike price Put The right to sell an asset at a specified time in the future for a specified exercise price

10. Page 10CS 851 1 March 2002 CCA We use “pricing by replicating” to cover the risks in owning options by developing a portfolio of stocks and loans with expected returns equal to those expected on the option. We “hedge” our risk by buying stocks without using loans and selling call options.

11. Page 11CS 851 1 March 2002 CCA IN SOME CASES THE MARKET HAS ALREADY PRICED THE RISK -- SAY IN AN UNPROVEN TECHNOLOGY -- Risk is based on the volatility of the value over time.

12. Page 12CS 851 1 March 2002 CCA If there are publicly traded assets for which there is market data, then we can use the market data to get a handle on the market’s perception of the risk, and we can use this estimate of risk to price a “real option” that is not traded (and therefore not priced by the market) but that is exposed to same risk as the twin portfolio — and to price it in a “market-based” way independent of the subjective estimates of risk by, for example, executives.

13. Page 13CS 851 1 March 2002 CCA The underlying assumption is that the market is a lot smarter than any executive…that collective wisdom, based on the opinions of many, is more reliable than the opinions of one.

14. Page 14CS 851 1 March 2002 CCA The Black-Scholes formula is C = [N(d 1 )*P] – [N(d 2 )*PV(EX)] where N(d 1,2 ) are cumulative normal probability density functions EX is the exercise price PV is the present value

15. Page 15CS 851 1 March 2002 CCA and where

16. Page 16CS 851 1 March 2002 Real Options Call Option on StockReal Option on Project Current value of stock Gross present value of expected cash flows Exercise priceInvestment cost Time to expirationTime until opportunity disappears Stock value uncertainty Project value uncertainty Risk-free interest rate